Tax-deferral can be a powerful tool. It’s generally recommended to maintain tax-deferral as long as possible. If, however, there is a need to access money saved in a tax-deferred IRA or employer-sponsored retirement plan before you reach the age of 59½, you may be subject to the 10% premature distribution penalty, in addition to the distribution being taxable as ordinary income. This penalty however does not apply if the distributions are part of a series of substantially equal periodic payments (SEPP) made for the longer of five years or until the IRA owner reaches age 59½. Under Section 72(t) of the Internal Revenue Code, there are three methods that qualify as SEPP. The details of each and the appropriateness of this strategy should be discussed with your tax advisor.
The Required Minimum Distribution (RMD) method: This method is similar to calculating an RMD, which results in the account balance, life expectancy and the resulting annual payments being re-determined each year. This method is most appropriate for a person who does not need a fixed amount each year, and likes the potential for their distribution amount to increase as the account balance increases, and is willing to take the risk of the distribution amount decreasing.
The Amortization method: The annual payments using this method are determined by amortizing the owner’s account balance in level amounts over a specified number of years. The account balance, life expectancy, and the resulting annual payment are determined once for the first distribution year, and the annual payment remains the same in each year thereafter.
The Annuitization method: This method calculates the annual payment by dividing the individual’s account balance by an annuity factor that is the present value of an annuity of $1 for the life of the owner. The annual payment is determined once for the first distribution year and remains the same in subsequent years. In many cases, this method is estimated to provide a higher payment amount than the Amortization method. Except in the event of death or disability, a change in payouts after a series of SEPPs has begun generally will constitute a modification and thus trigger a penalty. The IRS stated that an individual who begins distributions using either the Amortization or Annuitization method may, in a subsequent year, switch to the RMD method without triggering a penalty.
IRAs do not have to be aggregated for purposes of calculating a series of SEPPs. Depending on the annual amount needed, a qualified tax advisor can calculate the account balance required to produce that payment and may recommend segregating such amount into a separate IRA so as to maintain the tax deferral on the remaining assets. If you choose to base the SEPPs on the total of all of your IRAs, the annual distribution may be taken from any or all IRA accounts.